By Chris Pritchard, FIA, Associate at Barnett Waddingham
Why might a scheme invest in a partial buy-in?
The primary reason to obtain a partial buy-in is to reduce longevity and demographic risks in respect of the portion of liabilities covered, but it can also allow schemes to capture attractive insurer pricing in the commercial market. This can save costs in the long run and can add an element of price smoothing over time as future pricing risk is mitigated by the “locking-in” of a price at the time of each partial buy-in.
With a full buy-out the ultimate end goal for most Defined Benefit (DB) pension schemes, partial buy-ins have been seen as a key step on the journey (where a scheme’s assets and liabilities are transferred to an insurer in full). However, in light of recent events and current market conditions, it is worth reappraising the strategic rationale for a partial buy-in. We consider four key considerations:
Returns
Risk
Liquidity
Flexibility
What has changed?
Returns
Market conditions
Over the course of 2022, UK gilt yields rose, with September and October in particular seeing unprecedented volatility in UK gilt markets, putting a strain on DB pension schemes and their hedging strategies. This rise in gilt yields has led to a decrease in the value of both the assets and liabilities of schemes.
Corporate bond spreads have risen too. Therefore, the return sacrificed by investing in a partial buy-in, compared to investing in a portfolio of gilts and corporate bonds, is relatively high compared to recent history.
Use of leverage
Since the events of September and October, all Liability Driven Investment (LDI) strategies - commonly used by pension schemes to achieve their hedging targets - have taken steps to reduce the levels of leverage that are used in their funds. This means that to achieve the same amount of hedging as before, pension schemes need to allocate a larger proportion of their assets than they did previously to LDI and collateral. This leaves less assets available to seek returns and as a result, all else being equal, the return achievable on the residual assets after a buy-in will be lower than it was before, for a given level of risk.
These two key points weaken the strategic rationale for a partial buy-in from a returns perspective.
Risk
Longevity risk
The reduction in value of pension scheme assets and liabilities brought on by rising yields will have reduced risks in present value terms too. However, longevity risk will have been impacted more than other risks, and so will have reduced on a relative basis too. This is because longer-term liabilities, which represent a higher level of longevity risk given the amount of time and therefore uncertainty before those liabilities are due, will have a lower (relative) value placed on them compared to a time when yields were lower.
Longevity risk reduction from a partial buy-in is therefore less impactful on total risk than it was previously.
Liquidity
Illiquid assets and whipsaw risk
The gilt crisis in September and October 2022 has resulted in liquidity in pension schemes being under the microscope, with increasing scrutiny on schemes holding illiquid assets such as property, infrastructure or private debt. Such assets can be difficult to sell at short notice without having to sell at a heavily discounted price. A partial buy-in is also an illiquid asset, and even though market risks are reduced when a scheme enters into one, capital is locked up too.
The key point here is that schemes need to make sure their residual investment strategy has sufficient liquid assets to achieve the same level of interest rate and inflation hedging as before, and are not exposed to ‘whipsaw risk’. This is the risk that yields rise sharply, causing a scheme to reduce hedging as there are not enough liquid assets to meet calls for collateral, followed by a fall in yields at a time that hedging has been cut. This would result in a fall in the scheme’s funding level.
Entering into a partial buy-in is likely to increase exposure to whipsaw risk. Given we remain in an environment of potential high levels of volatility in gilt markets, this weakens the strategic case for partial buy-ins at the current time.
Flexibility
Reduced future strategic flexibility
We have set out below an example investment strategy for a pension scheme before and after a partial buy-in using market conditions and example levels of leverage in the new era of lower leveraged LDI.
The example scheme invests 45% of its assets in return-seeking assets and 55% in LDI and collateral assets, with a typical level of leverage. If the scheme’s funding level were to deteriorate, the scheme has the flexibility to increase the level of return seeking assets (within reason) without impacting the amount of hedging that can be achieved (as there is scope to increase the leverage in the LDI a little). The scheme’s liabilities are roughly 60% deferred and 40% pensioner.
A pensioner buy-in for half of the pensioner liabilities is then entered into, funded from the scheme’s hedging assets (and collateral). The residual asset strategy has a lot less flexibility when it comes to achieving both return and hedging objectives.
In order to achieve the same level of hedging with the residual asset strategy, the level of leverage from the LDI assets must now increase, and in this example will increase to a level that may not be sustainable in the new environment of lower leverage, especially if yields rise further. Therefore, either the scheme’s hedging target will need to reduce, or the scheme’s expected return will need to be lowered. There is very little flexibility should the scheme’s funding level deteriorate.
Finally, the uninsured liabilities for this scheme are now deferred-heavy. This may ultimately lead to a delay in the scheme reaching a full buy-out because the uninsured liabilities will be a less attractive proposition for the insurance market than a ‘more balanced’ mix of deferreds and pensioners.
Other considerations
Market appetite
The bulk annuity market is very busy. Insurers may prioritise full buy-outs over partial buy-ins at this moment in time, and so many schemes may well be better suited waiting until they are close to fully-funded on a proxy insurer basis before engaging with the market.
Larger schemes
For larger schemes (£5bn+), a series of partial buy-ins is likely to be the only practical way to achieve a full buy-out, and so slightly different considerations apply.
Summary
In summary, changing market conditions, lower levels of leverage available from LDI and a greater focus on illiquid assets have, in our view, reduced the number of cases where a partial buy-in does truly represent a cost-efficient reduction in risk.
Whilst we do think the strategic case for partial buy-ins has generally weakened, there will, of course, still be times when partial buy-ins do make strategic sense. Each scheme is unique and so there is no one-size-fits-all answer. But using the returns, risk, liquidity and flexibility framework above is usually a good way to think about the rationale for your scheme.
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